In an era of tight academic budgets, many U.S. colleges and universities are breathing a sigh of relief as a record number of foreign students apply to study here. It’s quite a windfall for the schools, as these students rarely get any scholarships or financial aid.

#-ad_banner-#But it’s worth it. With the exception of elite universities in other countries, the domestic academic opportunities simply can’t compare to the quality of a U.S. education. Nowhere is the situation of greater concern than China, which spends just 3% of GDP on education, compared to 5% in the United States and Western Europe.

The lack of resources creates extra pressure on the roughly 10 million students that take China’s high school entrance exam (Zhong Kao) or the country’s national higher education exam (Gao Kao) every year. That’s where the private sector comes in — and where investors can profit — from this education gap. Here’s a closer look.

You can look at investable opportunities in this sector as four distinct sub-groups: 

— K-12 preparation for parents that want their kids to land in an elite college, which accounts for two-thirds of the total non-governmental spending on education; 
— Distance learning, also known as online education, accounting for 14% of spending; 
— Language tutoring, which is essential in an increasingly globalized world, 9%; 
— Professional training, akin to our vocational schools such as DeVry (NYSE: DV), which accounts for 11%.

As in the United States and Europe, a college degree yields significantly higher earnings potential.

K-12 prep is not only the biggest niche, but it’s fast-growing as well, and it is currently the main investable theme for U.S. investors. According to iResearch, spending has risen at least 20% a year since 2008 and is now a $60 billion business. The rapid growth is understandable. As Chinese citizens climb into the middle class, they spend a significant amount of money making sure their children are well-prepared for the future. Analysts at Credit Suisse note that “K-12 tutoring is the sweetest spot in the broad education market due to resilient spending and high entry barriers against online invasion.”

How big is this potential niche? China has 94 million students in K-5, and another 68 million students combined in middle school and high school, according to China’s National Bureau of Statistics — those numbers are actually down slightly from prior years, due to falling birth rates. There is a simple catalyst for this niche to expand: Market penetration. In South Korea, which is further along the path of economic development, 70% of primary school students use tutors. In China, that figure is just 30%, though rising at a fast pace, according to iResearch.

The K-12 tutoring market is quite fragmented and no company holds more than 1% of the market. A glance at two U.S.-listed stocks gives a sense of the industry’s growth.

These companies aren’t pure plays on the K-12 market. New Oriental Education & Technology Group, Inc. (NYSE: EDU), for example, also offers English language training and distance learning. Those niches have slowed and as a result, the company’s sales are now likely to grow at a 15-to-20% pace in fiscal 2015 and 2016, below prior growth rates. Analysts at Credit Suisse, who see shares rebounding to $30, note that “the market has been overly focused on the ex-growth of EDU’s adult English tutoring business, while neglecting the still resilient growth of its K-12 tutoring service, which posted a 40% CAGR [compound annual growth rate] in FY11-14.”

Of equal importance at a time when investors still distrust many Chinese stocks, EDU has more than $1 billion in net cash and generates $300 million in annual free cash flow. Some of that cash is being earmarked towards buybacks.

I prefer EDU to TAL International Group, Inc. (NYSE: TAL), which lacks the scale and capability to roll up the Industry. The company is seeing sales and profit growth slow to a crawl. Still, shares hold value as they trade for around ten times projected 2014 profits.

Pivoting to the online education segment, China Distance Education Holdings Limited (NYSE: DL), which has fallen by half as investors flee Chinese small caps, offers a combination of more than 20% sales growth and a 3.6% dividend yield. In fact, the company pays out all of its annual profits to the dividend, implying a dividend boost in coming years, as EPS forecasts suggest an upward trend.

Risks to Consider: Spending on education is largely seen as a necessity, not a luxury, in China. These companies should be able to withstand any Chinese economic slowdown. Still a severe slump in China may lead parents to curtail spending if unemployment starts to rise.

Action to Take–> It’s hard to find many sectors growing at a 20% pace these days. But the Chinese education is a clear exception, benefiting from an ongoing trend towards extra-governmental education spending. Of the stocks profiled here, New Oriental Education & Technology looks best positioned for solid upside.

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